Our Own Worst Enemy

It has been said many times that the best way to predict the future is to create it. In the case of the property/casualty insurance cycle we do, in fact, create it. We, as an industry, sometimes just do not manage it as well as we should. But it is clear, that with the cycle it is a matter of control it, or it will control you. And the industry knows all too well what happens when the latter is allowed to occur.

Contrary to popular belief, the insurance cycle is not some uncontrollable mystical force that indiscriminately decides when and how its effects will be felt on the p&c insurance industry. It is not an impediment put into place by some unknown deity, nor is it an invisible hand or an unrestrainable market phenomenon. Rather, creation of the cycle is more aligned to the lemming or herd phenomenon.

According to Encarta: “When overpopulation of Norway lemmings leads to a scarcity of food and overcrowding of habitat, many thousands of the animals migrate in search of food. The migrators swim lakes and rivers, cross mountains, and eat all vegetation in their path. Eventually, some reach the sea; attempting to swim it as if it were a river, they are drowned.”

The herd phenomenon of mass or market psychology attempts to explain why large numbers of people follow a group into making irrational, illogical decisions just because others are taking the same actions. With equity markets, for example, the phenomenon could lead to the creation of a bubble, when masses of investors drive up the value of a company’s or sector’s stock due to what Alan Greenspan called “irrational exuberance”. The herd mentality could also spur a panic sell-off, which is triggered for no logical reason. With a financial institution, it could be a run on a bank that occurs due to irrational and baseless panic, and for p&c insurers, it could be a mass move to pull down prices due to a perceived oversupply of capital and increased competition for market share.

WHY THE UPS AND DOWNS?

Cyclical rate peaks and valleys in (re)insurance markets almost always come as a result of issues surrounding supply, rather than demand. In the risk transfer business the supply in question is that of capital – essentially, capacity.

In essence, the financial position of (re)insurers governs the cycle as industry players tend to increase prices and pull back on capacity when growth of surplus is flat or negative, investment returns are sour and catastrophic losses high, and lower prices and increase capacity when surplus is growing, investment returns are high and claims costs are manageable.

Because of price swings, (re)insurers often have to cope with extreme fluctuations in revenue and expenditure, which often deeply impact their profits.

According to the Swiss Re publication “The insurance cycle as an entrepreneurial challenge” , written by Rudolf Enz, deputy head of economic research & consulting at Swiss Re, these price fluctuations are detrimental in two ways: “On the one hand, they make it difficult to plan ahead for revenues and expenditure, on the other, they increase the cost of capital to the company.”

“Cedents react to price increases by buying less cover: they keep higher retentions, cede smaller lines, or even stop reinsuring some perils altogether. Conversely, when reinsurance rates fall, buyers reduce their retentions, extend their ceded lines, and want further perils covered…the price increases and price reductions over-compensate [for] the rises and falls they have triggered in demand for reinsurance cover,” says Enz.

He emphasizes the critical fact that in periods of lower prices, (re)insurers write more business (i.e. take on more risk and, thus, greater loss potential) than they do when prices are higher. This is counterintuitive because basic economics dictates that the opposite would be more sensible (i.e. that carriers take on more risk when prices are high and less when prices are low).

NOW, WHAT DO WE DO ABOUT THEM?

According to Enz, “there are – at least theoretically – supply-side strategies with which better results can be achieved over the cycle, with roughly the same volatility, than by passively standing by and allowing the cycle to take its course.”

The strategies are largely based on two approaches: varying business volume, and steering risk capital. “This entails reducing market share in phases with lower prices and increasing it again in high-price periods. The (re)insurer’s equity changes in parallel: in high-price phases it has to be increased, in low-price phases reduced again,” says Enz.

Varying business volume

The best way to manage business volumes is to direct capacity to where the highest economic value resides, i.e., to those lines, segments or geographic regions where the return will be the greatest. This means walking away from business when the price does not cover costs. If pricing is not quite where it should be, but there is still room for profit, it may be more reasonable for the company to write lower shares or to reduce exposure by insisting on higher deductibles/retentions or lower upper cover limits. Tightening terms is another way of reducing loss potential.

The challenge comes in properly diagnosing the market situation, i.e., in determining where in the price cycle the industry is, and where it is going – and doing so in time and with accuracy. Such a diagnosis requires a future-oriented market analysis. The accuracy of this analysis and the successful implementation of a company’s cycle management strategy, says Enz, depends greatly on the company’s access to underwriting expertise as it is this knowledge and experience that is needed to estimate how much longer the soft market is going to last and when prices are going to rise significantly again.

Managing a company’s adjustment of business volumes all comes down to proper timing. Monitoring the market, predicting market trends and accurately assessing prices all play an important role. However, if a company’s timing is off, the fallout is the same as it would be if it did not take any action at all. It may even be worse, because the company may have damaged business relations with brokers, cedents or insureds without getting any economic payback.

Steering risk capital

If a (re)insurer actively matches its business to the cycle, it needs to find a way to match its capital level to the volume of business written, as it will need more capital in the hard market phase and less in the soft market. This is a statutory requirement in most jurisdictions because increased premiums put pressure on the capital ratio for premiums to surplus, and vice versa. Having the proper backing capital ensures that a company is more stable, better able to meet its claims liabilities at present and in the future (even if it is hit with large shock losses) and more likely to weather a prolonged soft market and/or downturn in investment markets.

There are various ways to match capital to premium volume.

A first method, notes Enz, is for the company to make enough capital available to cover the maximum capital requirement in the high-price phase of the cycle and invest elsewhere the surplus capital that is not needed during the low-price phase. Here, he stresses two things. First, that the biggest challenge is to properly determine the amount of capital needed and the market timing. Second, that the capital invested elsewhere have similar characteristics to property and casualty (re)insurance: that it correlate as little as possible with the investments on the asset side of the balance sheet, and that it yield an equally good mean revenue. Says Enz: “Whether these criteria are better fulfilled by life reinsurance or by a hedge fund has to be decided on the basis of the investment opportunities available when the time comes, taking into account the possibility of double taxation of the alternative investment.”

A second method, according to Enz, matches capital with business volume by issuing shares at the start of the high-price phase and buying them back in the low-price phase. As this involves fixed costs – as high as 2-3% of th e transaction volume – it is only worthwhile if substantial changes in capital levels are required of the company.

The third method, according to Enz, is to actively manage retrocessions. Because reinsurance capacity is cheap in low-price periods, a larger part of the reinsurer’s business is retroceded to other reinsurers during these periods. Conversely, in times of high prices, it is customary to cut back on retrocessions. He notes that a more recent version of retrocession is the securitization of reinsurance risks on the capital market.

COMPARISON OF THE ACTIVE AND PASSIVE STRATEGIES: A MODEL

The following model (see Figure 1), which is explained in greater detail in “The insurance cycle as an entrepreneurial challenge” compares a passive strategy (i.e. “Average”) with an active cycle management approach where a company varies its market share by up to plus or minus 50% depending on market conditions.

The premium volume in the case of the passive strategy is 30 money units, the active strategy totals 31.6 money units, because of the higher market shares in the high-price phase. The cycle manager’s expenses are higher, in line with the company’s higher premium volume, and its reserves and capital are, on average, lower because it wrote less business in the low-price phase. This lowers the volume of assets available for investment and, thus, the return on equity. However, its claims are lower due to its smaller shares in the low-price phase. Accordingly, the cycle manager records a better technical result.

Overall, profit for the active strategy under the given assumptions (as noted in the publication) is 24% higher than that from the passive strategy. At 12.2%, the return on equity is 2.9 percentage points higher than the market average and the volatility of the return on equity is marginally lower than in the market as a whole. This means that active cycle management pays off well from an earnings/risk perspective.

CONCLUSION

From a tactical standpoint, cycle management is largely about timing. However, from a strategic standpoint, it is about management turning off the auto pilot, and taking over the controls manually.

It brings them much closer to the grassroots of their market, to a place where they not only can see, but also begin to more instinctually feel what causes the ebbs and flows of the insurance cycle, the negative impacts of which we always pin “on the other guy” and the positive impacts of which we always pat ourselves on the back for creating.

Cycle management takes those spectators who are ultimately responsible to their shareholders for the condition of their respective companies and puts them squarely behind the wheel.

And if they, as company managers, are to contribute to the process of permanently breaking the grip of that self-imposed choke-hold known as the insurance cycle – that is right where they belong.